APPLICABLE LAW UK
REVIEWED 8th March 2010
SUBMITTED 8th March 2010
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FAIFs
As of 6th March 2010, new rules and guidance are effective in the UK which allow for the establishment of authorised non UCITS retail schemes (NURS) which may invest up to 100% in other funds that may themselves be unregulated (with a limit of 35% in value of the scheme to be invested in the units of any one underlying fund). Those underlying funds can include (but will not be limited to) hedge funds and the rules therefore bring the possibility of retail “funds of hedge funds” to the UK market for the first time although Funds of Alternative Investment Funds (FAIFs) will not be restricted to investing in hedge funds and different types of alternative strategies could be employed such as investing in private equity funds or property funds.
The introduction of FAIFs will bring the UK into line with other jurisdictions (notably France, Germany, Spain, Italy and Ireland), which have already introduced retail funds of hedge funds with varying degrees of success.
The new rules also clarify existing rules and provide specifically for qualified investor schemes (QIS) to be established as FAIFs for sale to institutions and other sophisticated investors. For the purposes of this article the new rules in relation to NURS have been considered in detail.
Similar but, in certain respects, less stringent rules and guidance have been introduced in relation to QIS. It should be remembered that as all FAIFs will be non UCITS they will fall within the scope of the AIFM Directive and will potentially be subject to additional requirements when that Directive is implemented although that should, on the positive side, allow a FAIF to be sold into Europe where that currently is not an option.
Authorisation process
From 6th March 2010, an application may be made to the Financial Services Authority (FSA) for approval of a FAIF. This approval process will follow very much the same process as currently in place for the approval of authorised funds (with the FSA retaining the right to ask management companies to provide additional information, particularly in relation to their proposed due diligence procedures, processes and resources).
The FSA has stressed that as part of the authorisation process the manager’s FSA supervision team may be asked to confirm whether they believe the manager to be capable of carrying out the level of due diligence required.
Summary of the FSA’s Policy Statement 10/03
The FSA has published Policy Statement 10/03 on FAIFs, including feedback on Consultation Paper 08/04. The FSA’s Policy Statement 10/03 summarised the comments received on Consultation Paper 08/04 and explains changes made to the proposed FAIF rules as a result of these comments. The main points to note are set out below:
Repayment standards
This is a vital aspect of the new rules and the FSA have acknowledged that the FAIF model would only work if there was a more flexible redemption regime than the current limits under which NURS operate. FAIFs will have a greater flexibility in the time allowed to calculate NAV and settle redemption proceeds. Managers of FAIFs will have up to 185 days to settle redemption requests from the receipt and acceptance of instructions from an investor to payment of redemption proceeds, ie including any notice period.
Gates/deferred redemption (NURS only)
FAIFs operating as NURS will be able to defer redemptions in excess of 10% (or some other reasonable proportion disclosed in the prospectus), but deferred redemptions must be dealt with at the following dealing day in priority to new redemption requests (ie stacked gates only). A QIS can defer redemptions without these restrictions.
Master/feeder structures
Master/feeder structures are permitted. Where used, the master fund must abide by the same rules and restrictions applicable to the feeder fund (ie the FAIF rules). It is the responsibility of the authorised fund manager to monitor that the master fund is abiding by the FAIF rules.
There is no requirement, however, for the funds which the master scheme has invested into to comply with FSA Rules (which had previously been a concern).
Due diligence approach
The FSA have reiterated the importance of a thorough and accurate due diligence process to be carried out by FAIF managers on the schemes into which they intend investing. The FSA have retained their due diligence guidance which was already quite stringent but have strengthened requirements concerning the custody and valuation of underlying funds as follows:
• Custody: a FAIF manager will be required to carry out initial and ongoing due diligence to determine that the property of an underlying fund is held in safekeeping by a third party independent of the underlying fund’s investment manager and subject to prudential regulation (see further discussion below).
• Valuation: a FAIF manager must carry out initial and ongoing due diligence to ensure that the calculation of an underlying fund’s NAV and the maintenance of its accounting records, are segregated from the underlying fund’s investment management function. It is not clear how far the requirement for “segregation” goes in terms of analysis of the underlying manager’s systems and controls.
Genuine diversity of ownership
The FSA have confirmed that, as the tax regulations for authorised investment funds now include provisions concerning genuine diversity of ownership (GDO), these requirements are no longer required in COLL. To be clear, if the FAIF is a NURS it does not have to meet the GDO requirement but if it does then if can benefit from the HM Revenue & Customs (HMRC) “white list” and thereby be certain that it will not be regarded as “trading”. As the risk of “trading” for a fund of hedge funds (or any FAIF for that matter) ought to be law due to the nature of their holdings and usual methods of portfolio construction, a FAIF that is a NURS does not in practice need to concern itself with the GDO. A FAIF that is a QIS, on the other hand, does need to comply with the GDO requirements.
Cost benefit analysis
The FSA have reiterated that general and system development costs should be borne by FAIF managers and not the FAIF itself and that firms should factor in these costs when considering whether or not to launch a FAIF.
Leverage (NURS only)
The 10% limit on borrowing remains on FAIFs established as NURS. If a FAIF manager wants to have access to a higher level of borrowing, it should consider establishing a QIS which is permitted to borrow up to 100% of the NAV of the fund.
Commodities (NURS only)
The rules relating to investments in commodities have not been revised and a FAIF will be subject to the usual NURS rules permitting up to 10% investment in physical gold only.
Unapproved securities (NURS only)
The FSA have removed the combined 20% limit on investing in unregulated schemes and unapproved securities (eg unlisted stocks) but have retained the 20% limit on unapproved securities meaning that investment in unregulated schemes does not constrain the proportion of the FAIF that can be invested in unapproved securities (which remains at 20%).
Prime brokerage and custody issues
As part of the authorised fund manager’s due diligence process, the authorised fund manager must satisfy itself that “the property of an underlying scheme is held in safekeeping by a third party independent of the underlying scheme’s investment manager” (COLL 5.7.9R(1)(b)(i)). It is important to remember that this is a rule and not merely guidance, whereas COLL 5.7.11G(6) states as guidance that the authorised fund manager must “make enquiries or otherwise obtain information needed to enable him properly to consider the extent to which property of the underlying scheme may be rehypothecated and the potential impact of such rehypothecation on the NURS operating as a FAIF”.
These provisions require some further analysis, particularly in light of how hedge funds typically arrange for the safekeeping of their assets.
Firstly, the restriction in COLL 5.7.9R(1)(b)(i) would prevent a fund from being an appropriate target for investment by a FAIF, where the custodian and/or prime broker are not independent of the investment manager.
Secondly, the requirement that the property of an underlying fund be held in “safekeeping” is difficult to align with a prime broker’s usual right to rehypothecate assets of the hedge funds to whom it provides prime brokerage services. Once rehypothecated, the assets are no longer held in safekeeping by the prime broker, rather a client has a contractual right for the return of assets of the similar type and value which contractual right cannot as a matter of law be custodied. The question is whether the wording of COLL 5.7.9R(1)(b)(i) would restrict investment in underlying funds where their prime broker has a right of rehypothecation.
If COLL 5.7.9R(1)(b)(i) is construed narrowly, there is a risk that the vast majority of hedge funds would be unsuitable investments for the purposes of the FAIF rules. The more helpful interpretation of COLL 5.7.9R(1)(b)(i) is that an underlying fund with a prime broker that has a right of rehypothecation of its assets, will be permitted as an investment for a FAIF as any assets not rehypothecated will be “property held with an independent third party” thereby satisfying the requirement. As part of its due diligence process and in accordance with the guidance in COLL 5.7.11G(6), an authorised fund manager will need to assess the extent to which assets of that underlying scheme may be rehypothecated.
At this point it is useful to note that a prime broker in the US is prevented by statute from rehypothecating more than 140% of the indebtedness of its client. While there is no similar regulatory requirement here in the UK, it is usual to include a contractual restriction of a similar level meaning that there should always be property of a hedge fund held by a prime broker that is not subject to rehypothecation making it possible for a FAIF to overcome the hurdle of COLL 5.7.9R(1)(b)(i). How a FAIF manager will get comfortable as to the extent of an underlying fund’s arrangements for rehypothecation with its prime broker and the impact that these will have on the FAIF itself is not clear although the contractual/regulatory limitation on the level of permitted rehypothecation as a multiple of indebtedness to the prime broker will be a relevant factor.
Selling FAIFs
The FSA recognise that FAIFs (established as NURS) will permit the retail market to gain access to hedge funds and other unregulated collective investment schemes. To assist with the marketing and distribution of FAIFs to retail customers, they have prepared a factsheet with various points for distributors to consider when distributing FAIFs.
Tax treatment of FAIFs
FAIFs will be subject to the same general tax regime as other authorised investment funds (AIFs).
However, the Government has introduced new rules which apply from 6th March 2010 to AIFs which are “funds investing in non reporting offshore funds” (FINROFs). A FAIF will be a FINROF if it has more than 20% of its gross asset value invested in offshore funds which are non reporting funds (other than bond funds) or in other FINROFs.
A FAIF (other than a FINROF) which holds an interest in a non reporting fund is subject to corporation tax (at 20%) on any gain on the sale, redemption or other disposal of the interest. In the case of a FINROF, however, the gain is exempt from tax (as are all capital gains realised by a FAIF) but all gains realised by investors in the FINROF will be taxed as income (not capital gains) when they dispose of their interest in the FINROF. This replicates for investors the tax treatment of investing directly in a non reporting offshore fund, though it may be is advantageous if the FINROF holds assets which would not give rise to a charge to income tax on disposal.
A FAIF may also elect to be a FINROF. This would be attractive for a FAIF intended for tax exempt investors so that the FAIF may invest in non reporting funds as part of a wider investment strategy without incurring a tax charge. Such FAIFs may also wish to elect to be “tax elected funds” in order to stream income to the benefit of their tax exempt investors, such as pension funds and SIPPS (FAIFs are currently not qualifying investments for an ISA on a technicality which HMRC is working on with the FSA but in any event it is likely that FAIFs will only be qualifying investments for a stocks and shares ISA if the FAIF provides for at least bi monthly redemptions).
The effect of the FINROF regime suggests that the FAIF market may have to divide into:
• FAIFs which invest only in offshore funds which have reporting fund status or which are bond funds. These FAIFs will not be FINROFs so that they remain within the capital gains tax regime for taxable investors
• FAIFs which invest only or almost only in offshore funds which do not have reporting fund status, so that they are FINROFs and are within the income tax regime for taxable investors, and
• FAIFs which invest in both reporting and non reporting funds but which are marketed to tax exempt investors. These will be FINROFs, or will elect to be a FINROF if they do not meet the 20% threshold, so that no tax is incurred by the fund.
The need to split the market in this way is unfortunate although HMRC has undertaken to consult on how to address the issue.
The FSA/HMRC rules to accommodate FAIFs have been a very long time in the making. It is to be hoped that the time taken has been used to good effect in achieving a balance between allowing retail access to an important asset class and ensuring reasonable investor protection.
Article prepared by Catherine Weeks and Neil Simmonds of the Financial Services Group at Simmons & Simmons
